Andrew Lilico: What killed private capitalism?

Andrew Lilico is the Managing Director of Europe Economics, a leading authority on financial regulation and cost of capital analysis, and a member of the IEA/Sunday Times Shadow Monetary Policy Committee.  His pamphlet "What killed capitalism? The crisis: what caused it and how to respond" is published today by the Centre for Policy Studies and is available to download. He is also a regular contributor to the CentreRIght blog.

The credit crunch is the great political event of our era.  Over the next generation, much of politics will be defined by one’s reaction to these events.

At present, the left is divided between those who now regret having ever disavowed Marx and a belief in the crisis of capitalism, and those who merely believe that these events represent the end of a “neoliberal consensus” established in the period since Thatcher and Reagan.  On the right, so far the view has tended to be that this crisis arose from serious mistakes in financial regulation and monetary policy and perhaps also some lack of comprehension about the risks associated with high indebtedness, and that with more appropriate policy we should have been able to avoid being in the situation we found ourselves last Autumn.  That notwithstanding, the right has tended to concede that, once the crisis was in full tilt, there was no option but for the government to take over the banks.  A more radical strand on the right has it that, indeed, this was a failure of neoliberalism and that the response should be to remould the economic order inspired by localism and Catholic social theory

In my Centre for Policy Studies pamphlet, published today, I offer a different tale of how we got here, what should have been done last Autumn, and what we should do now.  According to my view, at the heart of the credit crunch was over-payment for innovations of a sort that recurs fairly frequently in a capitalist system.  We saw it with the railways, the lightbulb, radio, and dotcom companies.  In the credit crunch the innovations in question were new financial products and organizational system.  It was not a mistake or a “failure of capitalism” that these financial innovations were “permitted” any more than it was a mistake that dotcom companies were “permitted”.  That just is capitalism.  But there was over-payment so there were losses – significant losses, sufficient to imply the collapse of a number of the companies involved (as happened with the dotcoms or the railways).  Again, failure of companies when there is over-payment is not capitalism failing.  It is capitalism working.

Nonetheless, I do believe that policy contributed to making these overpayments worse than was inevitable.  In particular, financial regulation over the past twenty years has strived to replace the “buyer beware” (caveat emptor) principle (which was thought to have weaknesses in the finance sector) with regulatory badging by regulators and ratings agencies.  Because the system depended for its assessments on these few individuals, when they made mistakes (as was inevitable at some point) they made mistakes for the whole system – they coordinated the errors, creating added systemic risk.  The proper answer cannot be to have more invasive regulation, chasing caveat emptor even further out.  Rather, the regulatory strategy must be revisited, and responsibility for losses must be placed more squarely back with the providers of capital (including those buying retail financial products and making deposits).

There were other policy mistakes, including particularly in the monetary policy framework (inflation targeting), but the most important features in creating the initial crisis (the credit crunch itself, from summer 2007) were the vicious combination of over-payment for innovation and systemic coordination of errors.
Once the crisis was underway, however, further problems were exposed with the policy framework.  The most serious was the destruction of the traditional monarchical role of the Bank of England.  Its ability to deliver its lender-of-last-resort function was hobbled by its lack of prudential oversight and the inflexibility of the rules – particularly the Basel rules on capital adequacy.  With hindsight, it was a mistake to have belonged to the entire Basel framework.

In addition, policy-makers were terrified of the events of the early 1930s in the US, and refused to allow any significant institution to fail.  But in this scenario – where there were large losses associated with over-payment for innovation – it was impossible for the Market to heal itself without bankruptcies.  Refusing to permit failures would inevitably lead to an escalation, and did.

Once we reached Autumn 2008, and the sequence of events following the nationalisation of Fannie Mae and Freddie Mac in the US, the policy attempt to smooth things over and pretend nothing much needed to change in the sector should have reached its own reductio ad absurdam.  But policymaker denial knew almost no limits.  Somehow a consensus arose that providing support of more than a year’s GDP and losing more than 10% of a year’s GDP in the process, whilst nationalising much of the banking system, was the only possible route of action.  Even at an intuitive level, in the cold light of day, it must be obvious to everyone that this was a truly terrible decision.  Who can seriously believe that the recession would have been so much worse if we had done something else with the banks and used that 10% or more of GDP on tax cuts?  We’re likely to lose 6%-7% of GDP in this recession (if we are lucky).  Are those that support the bailout strategy really contending that if we had cut taxes by 10% of GDP but allowed the banks to fail then the recession would have been 17% of GDP or more?  Setting aside all the economic theory that explains why this would not have been true, it is a proposition that simply defies common sense.

Even had we just adopted laissez-faire with the banks, the final outcome would have been better.  But we could have done better than laissez-faire.  The key problem with the bailout strategy has been that those that had lent money to the banks – the bondholders – have been spared.  This has validated one of the strategies that created the problem.  Banks paid out high dividends whilst taking on extra debt, effectively increasing their gearing.  This increased their exposure to bankruptcy if anything went wrong.  When it did go wrong, therefore, the key losers should have been those that provided those bonds (provided that extra indebtedness).  But the government has spared those bondholders, making what should have been a terrible commercial decision into a good one.

Alan Greenspan and others angst about why market forces did not prevent this crisis occurring.  But market forces did have a mechanism for punishing the commercial errors involved – bankruptcy and losses for bondholders.  Government just did not let those forces act.

The correct response should have been to ensure that bondholders suffer. This would have involved some policy intervention.  In particular, governments should have acted to place retail depositors higher up the chain of claimants on banks assets, in the event of liquidation, than even secured bondholders (making the retail depositors “preferred creditors”).  This would have trampled on a notional property right of bondholders and thus would have required more than laissez-faire.  For depositors, it was not necessary to provide deposit insurance (there was no chance retail depositors were going to lose out in this scenario if they were preferred creditors – the very high leverage which created the bankruptcy risk would also have provided a huge asset cushion for depositors).  All that was necessary for depositors was to address their cash-flow problem by creating a national Deposit Access Fund (which would claim back deposits withdrawn, from the assets of liquidated banks).

Instead, governments chose to bail out banks with capital injections – keeping rich people rich at the expense of everyone else.  Such capital injections were misguided, for they misdiagnose the nature of the crisis.  This was not merely a crisis associated with past losses, which could be made could through recapitalisation.  Even setting aside the madness of bonds market innovations, the financial sector probably needs to shrink – even at the retail level bank business models had become heavily over-dependent on income from mortgages that was bloated by excessive house prices. With house prices in the future returning to much more traditional levels, retail banking, also, will need to be more modest.  Even the “boring bank” components of the current sector might not be profitable.

Such a profitability crisis will tend to eat up new capital injections – so that the bailouts become good money thrown after bad.  So, setting aside the question of the wisdom or morality of providing money to keep rich people rich even it would work, and setting aside the question of whether the money would have been better used for something else (such as tax cuts), the bailouts were never likely to work even in their own terms.  They were a sustained and expensive exercise in denial.

At one level, this is an allegory of British Socialism.  You take a system, flawed because all humanity is flawed, but which employs flawed human nature to create incentives.  Laziness, impetuousness, blinding greed, simple calculation error, bad luck – all these things lead to bad outcomes, such as unemployment or financial loss.  Those bad outcomes create incentives to minimize the errors involved.  But British Socialism has a tradition of locating these errors and then subsidizing them so that their bad outcomes are not realised.  This is no better (indeed, it is probably worse) when the flaws involved are those of the rich than when they are those of the industrial working classes or the unemployed.  It surely cannot have been the ambition of British Socialists to be the sponsor of the feckless lazy and unlucky capitalist?

Well, we are where we are.  Governments own much of the banking system and may yet nationalise more – especially once the bad debts from the recession really start to bite.  Given where we begin from, the key things now are (a) that the government should not provide more good money to throw after the bad; (b) that governments should accept their role as shareholders (who else is going to do it?) and force restructuring upon the banks; and (c) that if restructuring cannot deliver adequate profitability to repay current debts, then bondholders should be made to lose out.  The Market’s punishments for error or bad luck must be allowed to function.  If we do not allow risks that go bad to result in losses, the alternative will have to be regulation that prevents risk-taking (for otherwise risk-taking will certainly be excessive if there is no downside).  Without risk-taking, there will be less innovation, a less dynamic and diverse society, and slower growth in the economy.

Capitalism produces booms and busts. To have pretended otherwise is hubris.  We must not imagine that that hubris was merely Gordon Brown’s – as if he had not abolished boom and bust, but of course if we pull the right lever then we can abolish it. Whatever we do next, we must not aspire to eliminate all economic volatility, for we could only do so by eliminating the innovation that creates that volatility, thereby eliminating the key driver of our future prosperity.